CPA’s Guide to How Currency Forward Contracts Work

Currency Forward contracts are a very useful tool for everyone who needs to exchange currency. For a CPA, who needs to manage an account of finances, this contract can be an instrument of keeping revenues and expenses at expected easily manageable levels despite FX volatility. That volatility is a major issue at the moment because of the recession. However, it exists even at the best of times. Foreign currency exchange rates are in constant flux, which can throw off financial management. Forward contracts are a hedging tool that aims to remove uncertainty from international money transactions.

What Is a Currency Forward Contract?

A currency forward contract often referred to as merely “forward” or “FX forward contract”, is a hedging tool. In essence, this contract is a type of foreign currency exchange transaction. It’s an agreement between a seller and buyer of currency to complete the purchase at a predetermined exchange rate in the future.

In short, a forward contract is a tool that people who need to exchange currency can use in order to avoid the risks of FX rate fluctuations. It seems rather straightforward. However, there are a few important things you need to understand about this type of contract.

  • There is a specific future date for the transaction that cannot be changed. The contract must be settled on this day exactly, as opposed to spot transactions that must be settled immediately.
  • Forward contracts guarantee only the security of the FX rate used upon completing the transaction. It does not ensure that the rate would be favorable in relation to the true FX rate on that specific day. Therefore, while there is a good chance of saving money on this type of transaction, there is also a chance of losing a hefty sum because of it.
  • The duration of the contract can be set at the period between one and five years into the future. For major currency pairs, such as the GBP/USD or EUR/USD, the duration of the contract can be longer.
  • Forward currency contracts aren’t free. The cost of the contract, on average, is 10% of its total value paid upfront. The remaining 90% is to be paid at the date of contract settlement.

For a CPA, the main value of this hedging tool is that it enables you to keep all expected revenues and expenses tied up with domestic currency. As FX volatility can wreak havoc on accounting, forward contracts add a measure of security.

How Does the Currency Forward Contract Premium Pricing Work?

It’s essential to understand that the actual currency forward contract pricing has nothing to do with FX rates predictions. In fact, it’s calculated using a fixed formula used across the industry. Therefore, the easiest way to understand the price is to use a Currency Forward contract pricing calculator. It will give you a good estimation of the premium you’ll have to pay at the time of signing the contract.

Factors that take part in calculating currency forward price are:

  • Spot price for the currency pair at the moment
  • Interest rate differentials between two currencies
  • Time it takes for the contract to mature

As you can see, none of the factors is based on predictions. Therefore, a forward contract price is easily estimated at any given moment. It will not be affected by any changes resulting from the volatility in FX markets and the global economy.

Note that it doesn’t matter if the rate in the forward contract seems to be very different from forex forecasts. They will have no bearing on these calculations. The same way as the real FX rate at the time of contract completion will have no effect on the rate secured by the contract.

How CPAs can Use Currency Forward Contracts in Their Work

Any CPA today must understand the functions and implications of hedging tools. Forward contracts, in particular, have a major impact on businesses during times of economic crisis. In the global world of today, international money transactions are extremely common. A CPA must be able to manage them and advise on the safest FX strategies.

Because of the inherent volatility of foreign currency exchange markets, they present a massive challenge for financial management. Without the security offered by hedging tools, the value of any international transaction cannot be accurately predicted. Therefore, a CPA will be unable to maintain careful calculations for any future transactions.

However, forward currency contracts, and other similar hedging tools, remove the volatility factor. They may not ensure the best rate for businesses and entrepreneurs. But they guarantee the security of future calculations and evaluations.

They also present a great solution for removing the risks of foreign currency trading. During a recession, FX markets become very unstable. This provides an opportunity for spot trading, but exponentially increases risks to anyone with long-term plans of managing international transfers. With the help of hedging tools, those risks are cut to the minimum. Which might allow more businesses a chance to survive through a recession.

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